Why the Dow Is Vulnerable to Weak Oil Prices

The tight connection between the stock markets and oil prices has received a lot of attention this year, and for good reason. The correlation between the two reached the highest level in 26 years in January. In a time of financial and economic turbulence, all asset classes tend to move together—which is partly why the two are so closely aligned at this moment.

The fallout from the pain in the energy sector is touching large segments of the economy, including many major U.S. corporations with exposure to oil and gas.

A good bit of the linkage is the result of general market sentiment, psychology, and knee-jerk reactions. Bloomberg opined that the oil market has “hypnotized” equities. To a certain degree that is correct. At the same time, however, the fallout from the pain in the energy sector is touching large segments of the economy, including many major U.S. corporations with exposure to oil and gas. Some companies (if not all, given that most have operations overseas) are also taking hits from their activity in emerging markets, where lower oil and commodity prices have had more far-reaching effects than in the U.S. With this in mind, the correlation between the two isn’t unreasonable, although the extraordinary linkage made between the two in explaining the market rout may be overblown. To be sure, low oil and energy costs create savings in the costs of raw materials and transportation, while boosting consumer sentiment and disposable income, which benefit the majority of U.S. businesses and households.

The Dow Jones Industrial Average (DJIA), an average of 30 major companies traded on the New York Stock Exchange and the Nasdaq, is 9 percent lower year-to-date, while oil prices are down by almost 20 percent. The carnage for the Dow was worse in mid-January, and the index is recovered since its 2016 low, but more than 80 percent of the companies listed are in the red.

The Fuse has identified eight companies in the DJIA, more than a quarter of those listed, which have taken direct hits from the low oil price. Some are energy companies which would be expected to suffer, while others are less obvious victims of the oil price rout. Weakness in China and the U.S. Federal Reserve raising interest rates last year have also been key factors undermining the stock market. Nonetheless, if the oil market and the industry in general do not recover in 2016, the entire index is likely to remain under pressure throughout the year.

Apple

“We’re seeing extreme conditions unlike anything we have experienced before just about everywhere we look.”

It might seem odd that a company that sells computers, iPods, iPads and iPhones, but the California-based electronics manufacturer is seeing stress partly as a result of lower prices for commodities, including oil. The company’s stock price is down by 11 percent so far this year, in part because its push in a number of key markets outside the U.S., including China, is not going as well as expected. During Apple’s earnings call, CEO Tim Cook cited slowness in a number of oil-producing countries that are worrisome for the company’s outlook, and the global economy as a whole. “We’re seeing extreme conditions unlike anything we have experienced before just about everywhere we look. Major markets including Brazil, Russia, Japan, Canada, Southeast Asia, Australia, Turkey and the euro zone have been impacted by slowing economic growth, falling commodity prices, and weakening currencies.” The massive decline in Brazil’s real and the Russian ruble, which have fallen in part because of low oil prices, makes Apple’s products much more expensive in these markets.

Boeing

Just like Apple, it’s counterintuitive that Boeing, a jet manufacturer, would take a hit when fuel costs are so low. The company’s stock has plummeted by 18 percent in 2016, with oil prices a factor behind the plunge. The glut of airplanes in the U.S. has weighed on the company, contributing to expectations for lower commercial deliveries in 2016. But the fact that airlines have less interest in purchasing new fuel-efficient planes now that oil prices are so low is also hurting sales. Longer term, Boeing should benefit from the change in fortunes for airlines: The cost savings that companies are seeing from low fuel prices will allow them to re-invest in their fleets later on. There’s another issue hitting Boeing: Like Apple, Boeing sees emerging market growth at the core of its business. Almost 60 percent of the company’s revenue comes from outside the U.S. Under these circumstances, slower demand and weaker economic conditions in non-OECD countries and other international markets, some of which is the result of low oil prices, have disappointed Boeing investors.

Caterpillar

Falling oil prices have hurt Caterpillar, the largest construction and mining equipment maker in the world, in a number of different ways, pulling its stock price down 6 percent year-to-date. Caterpillar’s CEO said at the end of January that the oil price drop has been “the most significant reason” for the company’s decline in sales and revenue. Bloomberg Business calculates that Caterpillar’s sales to the oil and gas industry total $6 billion-$7 billion. While the energy equipment business in the U.S. has been hurt, so has its sales in oil-producing countries. The stronger dollar has not helped, since Caterpillar relies on exports. This year should continue to be a bruising year for the company given its large exposure to the oil and gas industry.

Chevron

Since Chevron is an oil producer, it’s obvious why the California-based major’s stock is down 7 percent this year and it tracks fluctuations in the oil price very closely. Prices have fallen so hard and so fast that it will take some time for investors to regain confidence in the sector. The company reported its fourth quarter earnings this past week, which were ugly. For the first time since 2002, it reported a quarterly loss. It has also laid off staff and is poised to continue to sell assets. More cost-cutting measures may be in store in order to improve its balance sheet, which could be pleasing to investors. Merger and acquisition activity has been relatively quiet in the oil industry, but there’s been a lot of speculation as of late, with Chevron cited as a potential buyer. Any action could hurt its stock price, at least in the short run, but help longer term—as long as the oil market rebounds.

ExxonMobil

Exxon is highly vulnerable to weaker prices, but the major is seeing its share price turn positive year-to-date—a relatively remarkable development given the health of the oil market.

Like Chevron, Exxon is highly vulnerable to weaker prices, but the Dallas-based major is seeing its share price turn positive year-to-date—a relatively remarkable development given the health of the oil market. The company is definitely performing better than its peers, as it hasn’t laid off staff and has moved forward with major projects. But $30 oil is still having a major impact, as the company’s revenue was cut in half last year and it plans to slash capital expenditures by some $8 billion in 2016. The reduction in spending has fueled speculation that it is ready to pounce in the M&A market. An acquisition would undoubtedly affect the outlook for this year, for better or for worse, but fluctuations in the oil price will determine how well the country’s biggest oil firm and the fifth largest company performs this year.

GE

For GE, low oil prices are a mixed bag, but the negatives are outweighing the positives at this point. The company’s stock is down about 10 percent this year as its industrial revenue is suffering from weakness in the oil and gas industry. Roughly 15 percent of the company’s industrial earnings are tied to oil and gas equipment. Late in 2014, when oil was 50 percent higher than current levels, CEO Jeffrey Immelt said the following about how low oil prices impact GE’s bottom line: “It’s probably close to a wash to a slight negative… I would say when our customers make more money, they spend more, but it’s going to have an impact on our oil and gas business.”

Goldman Sachs

The banking sector has underperformed this year for a variety of reasons, including worries about China’s slowdown and tighter credit markets, but bad loans to oil and gas companies in the shale patch are weighing heavily.

The banking sector has underperformed this year for a variety of reasons, including worries about China’s slowdown and tighter credit markets, but bad loans to oil and gas companies in the shale patch are weighing heavily. Goldman Sachs is one of the worst performers in the index so far this year, with its share price down 19 percent year-to-date. Last year, there were more than 40 bankruptcies in the shale sector, which is mostly comprised of small independents. More are expected to occur this year, further exposing the banks. As of January, Goldman had $10.6 billion in energy loans. That is only 2 percent of total loans, but enough to drag down its stock levels. With big banks having taken on energy loans that have gone bad, regulators may force the banks to boost reserves to cushion against more energy bankruptcies. The outlook is not promising, particularly with oil companies’ hedges having mostly rolled off, their access to capital drying up, and the difficulty in further cutting costs.

JP Morgan

Like Goldman Sachs and its other peers in the banking sector, JP Morgan is dealing with outstanding energy loans, prompting uncertainty among investors. The bank’s stock is down 15 percent year-to-date and will have to deal with the continued energy sector fallout through all of 2016. As of last month, it had energy loans of almost $14 billion. Similar to Goldman, energy loans for JP Morgan make up only around two percent of its total. The company’s executives believe that any fallout will be contained and that oil and gas industry are putting together the necessary adjustments. “The oil folks have been surprisingly resilient,” Chief Executive Jamie Dimon said in a conference last month, adding that costs have “dropped dramatically, and probably much more than most of us would have expected.” But banks have a habit of understating the risks they take. The subprime market was one example. Although the bad loans do not pose a systemic risk to the overall economy, investors are watching closely.

A rebound in oil price to save these companies?

A rebound in oil prices won’t save the companies from all that’s ailing them, but the low price and increase in volatility are making investors nervous.

A rebound in oil prices won’t save the companies from all that’s ailing them, but the low price and increase in volatility are making investors nervous. Another leg down in the oil markets, which is a possibility, would bring about more pain for these corporations, which make up more than a quarter of the DJIA. While cheap fuel prices are favorable to many business, the equity markets take direction from investment, and that is suffering from the plunge in oil and other commodities, here and in international markets.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.